Funding decision – what would you do?

Almost every bank board meeting I’ve attended over the past two years has included a lengthy discussion of interest rate risk. Boring I know, but topical given today’s low rate environment. It’s sometimes fascinating to watch the dynamics between board and senior management regarding major asset/liability decisions the bank must make. One such meeting occurred about eighteen months ago in the spring of 2009.

Let me set the stage. It’s May 2009 and you’re a director of a $500M community bank. The bank has a commercial real-estate concentration, but has largely avoided the credit quality pitfalls that have plagued the industry. Fed Funds has been at or below 25 basis points for the past several months. For the past several quarters the bank has managed its cost-of-funds on transaction deposits from 1.60% down to 0.51%. The bank is experiencing some deposit disintermediation and runoff but nothing excessive. It also has some wholesale borrowing that is maturing. Overall the bank is generally asset-sensitive, which means that their margin should be positively impacted when market interest rates rise.

For various reasons the bank is in need of around $80M in funding. I say various because there is no single event or crisis that caused this situation – it’s just through a variety of circumstances (deposit run-off, disintermediation, & wholesale funding maturity) that the bank needs to make an $80M funding decision.

Imagine you are a board member and the CFO presents the Board with these two options. The product is essentially brokered money market deposits or transaction deposits.

Option “A”

$80 million

5-Years

variable rate = Fed Funds+50bp

Floor = 1.00%

Option “B”

$80 million

5-Years

fixed-rate step-up 1.55…3.52%

Which one would you choose?

I should also add that the bank had just finished with a visit from the examiners. Their message, besides the given credit quality scrutiny, was to keep a close eye on interest rate risk. “Be prepared,” they said, “for market rates to rise…and fast.” The popular financial press echoed similar warnings: (Google News search: “rising interest rates, 12/1/2008-5/31/2009”)

“Rising Interest Rates Finally Start to Matter”

“Interest Rates will rise in 2010”

“Get Ready for Rising Rates”

“What to do when interest rates rise”

So with this heightened awareness of the interest rate risk you and the rest of the Board review an IRR analysis of each option. The report shows the impact each option would have on the bank’s interest rate risk. It shows what appears to be good news regardless of which option you chose. The projected margin is better (than the forecast) in both the +200bp & the +400bp stress-tests. In fact the stress-tested margin for Option “B” at +400bp is 3.95% which compares quite favorably to our base-case flat-rate projection of 3.29%. The decision is a “no-brainer” right?

Well, at the risk of being anti-climatic, I’ll tell you that the bank chose option “B”. Only…things haven’t worked out so well.

Prior to making this move the bank’s cost-of-funds was dropping like many of its peers:

before adding the funding

…5 quarters following the decision

However in the five quarters following this choice the bank’s core transaction deposit costs have risen. This during a time when their peers’ cost-of-funds continued to drop, or at-least leveled off. Too much attention was paid to the noise about rising rates (and perhaps to the benefit the bank would see if rates did rise soon…3.95% margin!) Not enough attention was paid to what would happen if market rates did not move anywhere. Now the bank is stuck with higher costs, whether market rates move up or not.

I’m not highlighting this decision because I think the bank’s board made a bad move. In hindsight it’s all too easy to judge the decision making of others. What troubles me about this decision is that it was probably made based more on the ill-informed advice of regulators and press headlines than anything else. “Watch-out”, they said, “rates are going to rise and there is likely to be trouble.” While that may be true, it just wasn’t true for this bank. The risk for this institution was if market rates continued to stay low (which they did).

The decision was based on what seemed to be good foresight. After all rates can’t go down much further. And the way the government is printing money, inflation is bound to kick-in, and the Fed will have to tighten, won’t they? That all sounds logical, only it hasn’t happened yet. I don’t know when it will happen - I’m not an economist (not that their track record is all that good either.)